Thursday, November 17, 2016

CalSTRS Sets Standard on Fee Disclosure?

The California State Teachers' Retirement System announced on Wednesday that it had calculated the total costs and fees paid to manage its entire investment portfolio, likely the first public pension fund to do so.

CalSTRS found total expenses, including carried interest, reached $1.6 billion in calendar year 2015, or less than 1 percent of the portfolio's $186 billion net asset value.

Presented for first time at Wednesday's meeting of CalSTRS' board, the new cost report marks a milestone among public pension funds to keep tabs on investment expenses and may motivate other funds to track their fees.

It also comes at a time when public pension funds, which manage the retirement benefits of public sector workers and retirees, face growing pressure to disclose the fees that they pay.

The task was not an easy one, however. CalSTRS has over 600 partnership investments, separately managed accounts, joint ventures and co-investments within its portfolio, and there is no industry standard for cost reporting.

As a result, to tally up all of the carried interest, management fees, partnership expenses and portfolio company fees paid by CalSTRS, information had to be collected one investment at a time through direct engagement.

"To the best of my knowledge, this is the most comprehensive review of investment costs," Allan Emkin of Pension Consulting Alliance said at Wednesday's meeting. "On the issue of transparency and disclosure, you will be seen as the new leader."

On Monday, CalSTRS sister fund, CalPERS, announced it had shared about 14 percent of the profit made on private equity investments in the past year with firms managing its private equity asset class.CalSTRS took fee disclosure a step further, calculating the fees and costs for its entire portfolio. Of the $1.6 billion, approximately 61 percent was external and internal costs, while 39 percent was carried interest, or profits shared.

CalSTRS said it paid an outside firm to compile the data, with the total cost of the project reaching $425,000 plus 1,500 hours of staff time.

Board members said the report was worth the money because it clarified important investment costs.

"This is absolutely fantastic," said Board Member Paul Rosenstiel. "I think it’s very well worth the time and the expenditure."

CalSTRS is leading the way once again with this initiative to be completely transparent by disclosing all the fees it pays out to external managers and track total expenses more closely.

Why is this exercise important? Because in a world of historically low rates, fees and other costs matter a lot more and they can add up fast, eating away at the investment returns over a long period.

You'll recall last month CalSTRS cut about $20 billion from its external manager program. A big part of this decision was a consequence of this exercise where they delved into what they were paying in fees and what they were receiving in return.

Kudos to CalSTRS as I honestly think it's essential to be as transparent as possible on every aspect of pension investments, including fees and benchmarks used to evaluate performance of various investment portfolios.

I give CalSTRS an A+ on benchmarks, communication and transparency. It was actually one of the pension funds I used as an example when I wrote a big report on the governance of the federal public sector pension plan back in the summer of 2007 for the Treasury Board of Canada.

Where CalSTRS fails to meet my governance standards is that it still has too much state government interference in its affairs, there is no independent qualified board to oversee its operations and while compensation is solid, it can be significantly improved as they bring more assets internally.

Think about it, they paid 39 percent of $1.6 billion in carried interest in calendar year 2015 which translates into $640 million. That doesn't include management fees, this is only carried interest (performance fees).

No doubt, pensions need to pay for performance, especially if they cannot replicate it in-house, I totally agree with this. But imagine they took 5% of that $640 million to hire people to manage assets internally across public and private markets, wouldn't they be better off?

In order to do this, they need to get the governance and compensation right, the way Canada's large public pensions have done. And that's where CalSTRS, CalPERS and most US public pensions run into trouble as there is way too much political interference in the operations of their pensions.

Having said this, sometimes you need some political interference to get these large public pensions to disclose things, like fees and total expenses. Here, I applaud California's State Treasurer John Chiang as he has put the screws on CalPERS and CalSTRS to disclose these fees.

Is it perfect? No, far from it, there are tons of hidden fees that were probably not accounted for because they were hidden and hard to find or because they decided to ignore these fees.

And let's not make this out to be more than it truly is, an accounting exercise. In fact, Leo de Bever, the former head of AIMCo who ran a similar exercise back in 2009 when AIMCo paid out $174 million in external fees to highlight the need to compensate internal staff properly, shared this with me:

This is just accounting – how hard can this be?

The problem may be that they used to subtract carried interest from return.

Capitalization of some structuring cost can be another issue – there are rules about what is capital and what is not.

Sure, accounting for all these internal and external costs isn't easy, especially if you don't have the right systems in place to track all these fees and costs, but let's not get ahead of ourselves here as there is nothing earth-shattering in tallying up fees and costs and many senior pension fund managers reading this will agree with me.

Still, let me be fair and crystal clear, I am for more transparency when it comes to fees and internal costs, and if CalSTRS is ready to set the standard in terms of reporting fees and costs, then I'm all for it.

In an ideal world, we should be able to read the annual report of any public pension to understand how much was paid out in management fees, how much in performance fees (carried interest), how much for internal salaries, how much to vendors, brokers, consultants, accountants, lawyers, etc. and exactly who received what amount.

This information is readily available but I doubt any public pension is willing to provide such granular detail. However, I remember a long time ago, a senior private equity manager of a large Canadian pension telling me how it would be nice if pensions reported the IRRs of their internal staff relative to their external managers. A lot of things would be nice, but they will never happen.

One thing is for sure, I applaud CalSTRS' new initiative and hope all other pensions follow suit in terms of disclosing total fees and costs and providing more specific information in terms of external manager fees.

Of course, the devil is in the details. I reached out to Chris Ailman, CalSTRS' CIO, to discuss this new initiative but he's tied up in board meetings today.

The latest CalSTRS board meeting (November 16-17) isn't available yet but it will soon be made public here. Below, you can watch the September investment committee and I will edit this comment once the latest board meeting becomes publicly available.

I also embedded Part 1 of the compensation committee that took place back in June. Listen carefully to the discussion on why CalSTRS changed its private equity benchmark and why it's tough to nail a proper benchmark not just in private equity but other portfolios that are being ramped up right now (like the 'RMS" portfolio).

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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